A German Lesson
In the days before paper currency, there were very few money supply problems. As populations grew and society shifted from agrarian to industrialized economy, the ever-expanding need for more money in the money supply accelerated. Thus, paper money was introduced.
To get people to accept paper currency as something of value, the governments made paper money redeemable for gold or silver on demand. Within a little more than a generation, paper money was commonly accepted.
After WWI, Germany was destitute. It not only lost the war, Germany had to pay reparations to France and England as Germany tried to rebuild its economy. But the winners deprived Germany of the coal and iron needed to rebuild its economy. The Weimar Republic, formed at the end of the war to manage all government affairs of Germany, decided to stimulate the economy by printing more money without each German mark backed by gold or silver.
The thinking of the government officials was to print money so everyone had plenty. By 1921, it took a wheel barrow full of currency to buy a loaf of bread. Factory workers were paid twice a day so their spouse could spend the morning’s earnings that very afternoon before the buying power significantly declined by the next morning. People were burning German marks in their pot belly stoves to heat their home because the currency was cheaper than wood or coal.
Monetary Policies
As a result of the crushing inflation in The Weimar Republic, the research to learn how to manage an economy’s paper money supply without destroying the economy became a major academic endeavor around the world.
Monetary Policy refers to the management of a nation’s money supply. The U.S. Monetary Policy is managed by the Federal Reserve, a private corporation formed in 1913. It determines how much currency is printed, interest rates, and mandates the percentage of bank deposit reserves. Generally, monetary policy is described as either “easy money” (print more money, low interest rates, less bank reserves) or “tightening policy.” These are the tools used to balance economic growth and inflation.
Fiscal Policy refers to cash flow; how much savings plus income plus how much is borrowed versus how much is spent. The U.S. Congress and the President manage the Fiscal Policy of the U.S.
After The Weimar Republic monetary disaster of 1919 to 1924, the need to better understand and manage paper currency motivated economic institutions around the world to research and study money supply management to sustain a nation’s economy without runaway inflation. Within about 35 years, two types on Monetary Policy were developed:
The Keynesian Theory is that a nation’s economy is managed by adding money to the money supply to stimulate economic growth and reduce the money supply, when necessary, to control inflation by retarding economic growth. British Economist John Keynes created this theory and it was widely accepted.
Keynesian Economists believe it is impossible to have economic growth without inflation. Most politicians prefer this monetary policy because they can buy votes with taxpayer money. Print money, loan or grant the new money to build projects (solar fields and wind turbines in vogue now), do research on worthy projects such as curing cancer to unworthy projects such as how do owls select locations to build a nest.
The current Federal Reserve leadership uses the Keynesian rule book to manage the United States economy.
The Friedman Theory was created by American economist Milton Freidman, who, after a few decades of study, thought John Keynes’ monetary management method was a hit or miss approach that frequently made wrong assumptions about the economy. Worse yet, corrupt monetary managers were able to manipulate the money supply to benefit selected groups and individuals.
Friedman decided that the government’s job is to create an environment to allow economic activity to flourish and then add paper currency to increase the money supply equal to the percent of economic growth. This allowed a growing economy without inflation and no need to make assumptions about future economic growth.
For example, if the gross national product grew 2% last quarter, increase the money supply by 2% this quarter. Simple as apple pie.
Managing the Money Supply
Conservative people prefer Friedman’s form of monetary management because one can have good economic growth with no inflation. President Ronald Reagan called this Supply Side Economics when he was running for president in ’76 and ‘80. Reagan was heavily criticized by Republicans and Democrats alike, but he never wavered. “VooDoo economics” is what his political opponents called it.
The easy money policy from 1974 to 1978 was an unintended result of the Arab Oil Embargo of October 1973, but that is a discussion to have another day. Many a farmer went to his lender in mid-70’s hoping to borrow enough money for newer used 2-wheel drive half-ton pick-up and came out with enough money to buy a brand new 4WD heavy duty three-quarter ton pick-up with all the bells & whistles and a fancy livestock trailer to pull behind it.
Inflation hit 13.9% by 1979. Thirty year fixed mortgages were not available. Uncle Sam was paying 16% interest on 10-year bonds. Banks were paying 15% on six-year CD’s.
Regan was elected by such a land-slide in 1980, the Democratic Congress said, “Yes, Sir, Mr. President, we will pass whatever legislation you want.”
He said reduce government red tape for businesses to form and grow, reduced tax rates by 50% so businesses and their employees has more money to spend, which created more jobs so more people will be paying taxes.
Eight years later, the total dollars of income tax paid to the Federal government was double what it was when Reagan took office. Reagan’s policies were right out of Milton Freidman’s text book and it created the longest period of economic growth in the history of the U.S.A.
October, 2023 Update
Roger, any thoughts on how bad inflation is going to get? Thanks, Mike
The Consumer Price Index (CPI) is the measure of inflation at the retail level of an economy.
The Producer Price Index (PPI) is the measure of inflation at the wholesale level.
Both indexes are a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. The representative samples used to calculate CPI and PPI has already been changed twice by the Biden Administration to report an inflation rate lower than it would have been otherwise. Therefore, saying what one expects the peak inflation rate to be at its worst is relatively meaningless.
In August 1971, six months of national wage and price controls were put into effect because inflation reached the “intolerable” level of 3%.
Inflation the past four years has been similar to the late 1970’s. The U.S. began exporting significant amounts of grain in 1972. Worldwide grain demand in 1974 exploded and continued until January 1980. The cost of everything related to grain production exploded. Easy money caused the inflation rate to explode, the same as what we have seen the past three years. My dad bought a new JD 3020 in June 1965 for $6,500. That tractor had 5,200 hours on it in the fall of 1973 and sold at auction for $7,400. If Dad had held on to it three more years, he could have gotten $12,000+ for it with 8,000 hours.
The CPI peaked in 1979 at 13.9%. The prime interest rate peaked at 21½% with a 1½% increase on December 17th, 1980. The thirty-year mortgage rates were all variable rates adjusted every year after 1976. By 1985, one could finally get a 30-year fixed rate, but it was 11%.
In 1980, the US government was paying 16% on 10-year bonds on a national debt of $914 billion. The national debt is now 31 times larger than it was in 1980. In Fiscal 2023 (began 1 Oct 2022), the USA income was $2.05 trillion and it has spent $3.15 trillion.
The US government is paying an average rate of interest this month of 2.07%. If that rate gets to about 7 to 8%, 100% of the U.S. government’s income will go to interest and the Federal Reserve knows it. The fed will not let interest rates get that high. So, how will the inflation rate be reduced to 2%?
The first step is to change monetary policy from Keynes Theory to Friedman Theory, but that will not happen with the current leadership. Some economists think we will wake-up some morning to learn that the dollar has been devalued to 10% of what it was the day before. Not only will your debts be reduced by 90%, so will your assets and paycheck. I do not see how that solves the loss of buying power of a currency.
I think the actual inflation rate this past year has been more than the 13.9% we saw in 1979. If the government prints money to pay the national debt, we will go to an inflation rate of over 100%.
In summary, I do not have an estimate of how high the inflation will go, but disaster for the U.S. economy is just beyond the horizon.
October 2024 Update
The government did away with the debt ceiling last winter and the country is borrowing a trillion dollars every 95 days. The way inflation is calculated by the government was changed last summer for the third time since Biden became president so inflation would not look so high. As a country, the U.S. financial situation is in far worse shape than a year ago. This month, for the first time in history, the U.S. is paying more in interest than on its national defense and the U.S. spends more on national defense than probably the next top ten spenders on defense combined.
What will happen when Uncle Sam announces there will be no more food stamps, free school lunches, no more disability payments, no more food health inspections, no more student loans, or bailouts for the post office, no more Medicare, Medicaid, and Social Security, etc.?
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